Joel Greenblatt literally wrote the book on special situation investing, so it's fitting that he teaches the Value & Special Situation Investment class at Columbia Business School.

This particular lecture is interesting because it encompasses a wide spectrum of the value framework; a special situation (spin-off) and a wonderful business (Moody's). It is also caught my attention because it features Rob Goldstein, partner at Gotham Capital. Before this lecture I was familiar with just one-half of Gotham's high performing investment partnership.

Goldstein does a case study of Moody's (MCO), which went public via spin off from Dunn & Bradstreet (DNB) in September 2000. The challenge is paying up for quality. To find a comp., the Gotham team used Buffett's 1988 Coke (KO) investment as an example of paying a premium for quality.

I have a fond opinion of Moody's as when I was a credit analyst, Moody's was was the more conservative of the rating agencies, and I used the "Moody's medians" as the benchmark for much of my coverage ratios.

The second half of this 2 hour+ video is Greenblatt lecturing on "The Little Book" to his CSB class. That will be the second of two posts from this video.As usual, if you don't want to watch an hour of video, my notes are below. All the charts I've included go to the time of the lecture November 2006, for proper perspective.

My Notes:

Gotham came across Moody's in 2000 when spun off.

It is one of the greatest business they've ever seen, but its not cheap.

Moody's was spun off at 21x forward earnings, 24x trailing earnings. They typically bought at 10x earnings at that point.

Coke as a comp:

Q: Why compare Moody's to Coke? A: One of the best franchises ever, Buffett bought at a high price but it continued grow and was cheap in retrospect. It's a high hurdle.

Q:What was so great about coke? A: High ROIC, great brand name, safety of franchise, easy to understand, predictable business.

Three important things about Coke: organic growth, high ROE, lasting competitive advantage.

Moody's:

Moody's: founded in the 1900's, originally charged investors for bond ratings, but ratings became so important, that debt issuers began paying for the ratings (1970s). Pay for rating or face higher borrowing costs.

Moody's and S&P each have 40% market share, and most issuers pay both.

Over past 19 years before 2000 spin off, Moody's revenues grew at 15%, operating profits grew at 17%. Revenue grew almost every year (with one exception).

Can we extrapolate this forward? What is the BTE? Goldstein believes that there is no chance of a 3rd major player.

Student brings up Fitch. Goldstein says they are a niche player. They are a big part of the other 20%. No one likes two dominant players but there is nothing they can do about it. Various solution suggested. There is not a practical solution to problem. Also one would be messing with the balanced workings with financial markets.

Revenue model: Fee on issuance, fee to maintain rating. but fee's are very low relative to face value of debt. Emory's note: This is like the path critical, low cost relative to value, ideal business as mentioned by Jeffrey Ubben of ValueAct.

Concluded Moody's is a great business.

Moody's did very well over time due to the rise of bond issuance globally, securitization.

Growth Rate (GR)/Reinvestment Rate (RR)= Return on Equity (ROE). For Coke this works out to 12%/20%=60%

For Moody's: What growth rate can we assume? Make assumptions about volume and price.

We can expect volume to grow, based on Asia demand, ect. They settled on 12% operating earnings growth rate, based on historical performance, and they don't see the drivers changing. This also matches Coke, for an easy comp.

What is the return on capital? Since Moody's gets paid on time or in advance of delivering service, and there is no physical good to deliver, the return on capital is higher than Coke. In fact, it is infinite (denominator is zero), due to the pre-paid nature. Very few businesses can claim to have infinite ROC.

Coke needed to spend 20% of its earnings on reinvestments, while Moody's needed to reinvest none of it. Coke produces $0.80 on revenue, Moody's produces $1.00.

Question: Does that mean Moody's is worth 25% more than Coke (all things being equal)? Answer, yes, at this time, but as growth rates decline the story changes.

For Coke: Rearrange GR/RIR=ROE to GR/ROE=RIR if growth declines to 5% --> 5%/60%=8.3% Reinvestment Rate has declined from 20% to 8.3% as a result of lower growth.

So to split the difference they decided Moody's was 15% better than Coke (not 25%). This is a more conservative assumption.

Coke's P/E when Buffett bought it was 13x. If Moody's is 15% better that is a P/E of 15x (13*1.15=14.95)

They were very comfortable with management. Management were good, and didn't think they were going to screw it up. Buffett owned it, management spoke with him.

Management compensation was in line, and they said they would return all excess capital through buy backs.

A note on interest rates: They declined from 9% to 6% from Buffetts Coke 1998 purchase to the Moody's 2000 spin-off. A bond would have gone up 42% over this time, which matches that 40% premium we factored in before.

Buffett made 185% in the first 3 years after Coke purchase, afterword made 18% annually

In the first year after spin off Moody's was up 50%. Gotham sold too early, but it was 30x earnings. Holding on looks easy after the fact.

In 2001, profits were up 40%, and the next few years were up 25%. Drove shares higher.

Greenblatt: We did learn something from selling too early. When we have one of the top five businesses of all time, we need to think three or four more times before we sell, after you've bought it well.

My career in asset management started with Federated Investors' municipal bond group. As an analyst, I reported to the Sr. Analysts and Portfolio Managers. The talented team at Federated has a deep expertise in municipal credit.

Therefore, Lee Cunningham is the best person I know to answer the question "Is Chicago the next Detroit?" As Sr. Portfolio Manager, he runs Michigan focused and High Yield municipal bond funds for Federated Investors.

Today's opportunity set will soon be gone and tomorrow, the next day there will be new ones.

Uses no leverage, with the exception of non-recourse debt in real estate investments.

We put 100% of employees net worth in the fund.

Part of his edge are great clients. Wealthy individuals and US Endowments/Foundations, not sovereign wealth.

Sometimes you lose money on a mark-to-market basis to make money by buying a lower price.

A very flexible mandate is part of his edge. His portfolio has gone from equities and distressed debt to many different asset classes.

Doesn't silo capital, we may allocate all money into the best opportunity/asset class.

At the time of this presentation (2010) one could buy a building at 1/3 to 1/2 the value of a REIT.

Firm structure and culture is part of his edge.

Relationships with people who source investments are part of his edge.

Flow of an investment idea within Baupost: Broker calls trader, who forwards it to the head of the group, hands it to analyst, analyst delivers research back to head of group, who hands it to Klarman for approval.

Build broker relationships when times are good, so that they come to you in times of market stress.

Ethan Berg is a management consultant turned investment partnership manager. He worked for six years at Michael Porter's Monitor Group. Of course, Porter is best known for his Five Forces analysis. As a management consultant Berg brings a unique perspective, a certainly a different methodology to value investing.

If you've ever worked with a management consultant, you know they have buzzwords and terminology that can be foreign to an investment manager. This interview is no different. "Assets and Activities", and "Activity Webs" are discussed at length. However, don't be deterred by this seeming foreign language, these are simply tools to gain a deeper understanding of Economic Moats. Listen below, and check out my notes further down the page.

This interview comes to us from the must-listen Value Investing Podcast by John Mihaljevic, CFA, author of The Manual of Ideas. More about Berg from The Manual of Ideas:

Ethan Berg is the founder and chief investment officer of G4 Partnership, an investment partnership dedicated to the implementation of the investment discipline of Ben Graham, Warren Buffett and Seth Klarman. Prior to founding G4 Partnership in 2000, Ethan was a management consultant at Monitor Group for six years, including two years of working directly for Michael Porter.

Porter's firm used many different analysis, but best known is Five Forces. Also used nationwide analysis. Berg developed Advantage Curves analysis.

They dove deep into customers relationship with companies and brands.

Southwest Airlines (LUV) competitive advantage was based around one type of airplane. Bought airtran and eroded their competitive advantage. No longer one airplane type. Comprising Moats to grow is a difficult trade-off.

For reference, here is a chart of Southwest's ROIC over time, the Airtran deal closed May of 2011.

Berg likes to read founder biographies, it gives him a sense of company culture.

As a management consultant, he cold called people at a companies. Asking questions was very valuable, investors don't typically do this, spend more time with IR.

What is strategy: Where and how do we compete? On what attributes do we win?

Steinway Piano: 90% market share of professional pianists for over 100 years. Pianist talk about the "Voice" of a Steinway piano.

Pianist have a emotional connection to the brand. The customer experience is built around supporting pianists in extraordinary ways.

They have a single source of wood that is a competitive advantage.

Note from Emory: I was recently a jazz show. Yamaha was the piano sponsor. Not to be outdone, Steinway provided the chairs.

No pianos are given away. Even official Steinway pianists pay for their piano.

Steinway sold to PE firm in 2013. Berg cautions the existing factory, facilities, and people are the competitive advantage. If these were changed, all that remains is the brand.

Compare Operation effectiveness vs competitive/strategic advantage:

Operational effectiveness: tweaking existing operations for small gains. Strategic Advantage is doing something different than competitors. Steinway operates very different than other piano manufacturers.

Google (GOOG): He generally doesn't invest in technology companies. Noticed Google because trading at 10x FCF. Had 70% market share in search. "Free options" on Android, G+, Google Wallet. These are all deepening the moat.

At the time, Google was the preferred employer for talent. Microsoft was a second tier.

Porter's Five Forces, can be helpful to managers inside of the company. "Activity systems" or "Activity Webs" are more useful for investors assessing strategy.

Assessing competitive advantage internally can be very uncomfortable for companies.

Can you price above competition? If not do you really have a competitive advantage?

Merrimack Pharmaceuticals (MACK): Can pay below industry salaries because so attractive to top tier talent.

Merrimack has a unique culture and operation structure that makes it very attractive . They do things differently. Cross functional teams organized by product, not by function.

Like local business journal, as they provide anecdotal information about the companies.

Read the HBS case studies if there is one on your company.

Make a hypothesis about the company. Ten things. Then check your hypothesis against feedback from those familiar with the company such as employees, competitors, suppliers, customers, and management consultants.

It all begins with the customer. AT&T was focused what they can do, not what the customer wants. They is a function of its long time monopoly status. Investors often thing of what a company does, has, market share. However investors should focus on what customers want.

The ideal company can deliver what the customers want and a strategically advantaged way.

Costco (COST) may deliver what customers want in a less expensive and fundamentally different way.

Five Forces is very applicable to assessing long term strategic advantage. What are the threat of new entrants? Will new technologies disrupt my long term competition advantages? For example he believes genetic testing does not have a long term competitive advantage.

What sets of analyses are most applicable from Monitor management consulting to Investing? Who are the customers, what do they value, and how does the company deliver that value? Easier to do in pure play companies than conglomerates.

Biggest mistake investors make when it comes to competitive advantage? The low bar they set for competitive advantage. Its not just taking market share or having a high ROE.

The common perception of activist investing is personified by Carl Icahn. Activists are known for using PR campaigns to exert pressure and affect change at target companies.

However Jeffrey Ubben of ValueAct is among the world most successful activist investors, and rarely goes public. In fact, he says public campaigns are less effective in unlocking value than his collaborative approach.

Approach in summary: buy undervalued companies at a discount in public markets, get board seat/control, affect change and improve operations from the inside, sell to private equity at a premium.

Other activists seek a short term exit, and it's often too soon. They are outsiders, and there is an informational disadvantage vs inside, collaborative approach.

No-media approach is a competitive advantage vs typical activists.

"We spend a year before we are fully invested". After 3 months of research they might buy some shares.

Typical company: Has recent under-performance, has concentrated industry structure with a dominant player so the customers don't want them to go away.

Won't buy 10% of a company without engaging management, if management is not interested in suggestions they back off.

Activist becoming directors solves much of the agent/principal problem.

Suggests Enron/Worldcom/ accounting scandals has been caused by boards that were asleep at the wheel and insulated by the board structure and poison pills.

Having liquidity at the hedge fund level creates short term pressures, and short term activist investors. So having the right investors in your fund is critical.

Many of their companies have core business, which in the past grew at high rate with large margins, however profits were re-invested poorly. "Turn off loss makers". Get back to core competencies. Become a pure play. Use cash from divestitures to buy back stock.

They like companies where product is a small part of customers cost structure but it is a critical path, so pricing is on value not cost.

As free preview to the Chimera article, below is a list of the best performing healthcare specialists, judged by replicating the holdings disclosed in their 13F filings. For details on how these portfolios were constructed, see the geek notes below.

As implied by the article title, I identify the best performing healthcare focused hedge funds from the list of 35+ 13F filers I track. From this list I created a "best ideas" portfolio by looking for stocks that multiple managers own. The intuition is this: if two biotech specialists with great track records, who are presumably competitors, are both in the same stock, its worth a look. The entire article, including stock picks, is available over at Chimera Research Group.

To be perfectly clear: These are the not returns of the funds listed, rather they are the returns of buying the stocks listed on the fund's 13F filing.

Portfolio Construction Notes:

All data pulled from 13F filings.

Top 20 holdings, equally weighted, long only.

Healthcare stocks only.

Portfolio rebalanced 46 days after quarter end, as filings are due 45 days after quarter end.

Backtesting all 35 healthcare hedge fund 13F by the criteria above, these are the best performing 13F portfolios over the past one, two, and three years. The data is from Whalewisdom.com.

The market is buzzing about Biogen Idec ph1b BIIB-037 data for Alzheimer's disease tomorrow. The press release is coming out at 5:35 am EDT. BIIB represents a 9.72% holding for most common benchmark in biotech, the Nasdaq Biotechnology index, the ETF that tracks this index is IBB. Other ETF's with large exposure include BBH, and PBE.

The data are widely expected to be positive. Either way, it will move the sector. Best of luck.

A must read book for any value investor is The Warren Buffett Way by Robert Hagstrom. Now in it's 3rd edition, the book profiles Buffett, his process, and deconstructs his most well known investments. It provides a valuation framework and quantifies Buffett's famous Margin of Safety.

Unlike many of Buffett the books out there, this one is by and for investment practitioners. Robert Hagstrom is Chief Investment Strategist and Managing Director of Legg Mason Investment Counsel. The forward to the first, second, third editions are by Peter Lynch, Bill Miller, and Howard Marks, respectively. While it is not endorsed by Buffett himself , Hagstrom reports he was granted permission to quote extensively from Buffet's letters, after he had reviewed the book.

American Express is one of Buffett's best known investments, and it is well examined in the book. This is the first in a series wherein I'll review a valuation from the book, and then perform an updated valuation of the company with the same approach as the author.

Buffett has actually gone several rounds with American Express, first with The Buffett partnership during the Salad Oil Scandal in the 1960's and then again with Berkshire in the 1990's when he infused AXP with capital via preferred shares during a cash crunch (sound familiar?).

Buffett converted his preferred to common in 1994, after AXP management sold off under performing divisions and began buying back shares. He bought more in 1995, owning almost 10% of AXP.

In the 1990's American Express situation , it was approapriate to use net income, as non-cash charges roughly equal capex.

The author uses the following conservative assumptions:

10% owner earnings growth for 10 years, followed by 5% growth after. Management was guiding 12% to 15% net income growth at the time.

A 10% discount rate, at the time 30 year treasuries were yielding 8%

Based on these assumptions, he concludes that Buffett determined AXP had an intrinsic value of $43.4B while its market cap was only $13B. A whopping 70% margin of safety!

There are a host of qualitative factors to consider. The author goes into AXP's consistent operating history, and management rationality. You'll have to read the book if you want a discussion of those.

Of course, since 1994 AXP has performed very well.

To assess the current valuation we are going to carry forward the authors assumptions about owners earning's being equal to net income. Over the past few years, depreciation, depletion, and amortization has roughly equaled capital expenditures at AXP, so we are going to keep that simplifying assumption.

As for owners earning growth rate, AXP management is still targeting 12% to 15% long term growth, same as 1994. Now that is consistency!

To be conservative we are going to keep our model's growth of 10% for 10 years, and a terminal growth rate of 5% after 10 years.

As for discount rates, long term treasury rates are much lower today than 1994. However, I love building conservative assumptions into my models. This way, if your valuation work points to a screaming buy, you know its not because of your optimistic assumptions. For these reasons we are going to stick with a 10% discount rate.

One interesting take-away from the book is Buffett doesn't adjust his discount rate up or down to account for perceived risk. Rather, he demands a larger margin of safety. This is just another example of value iinvesting contradicting the approach taught in business school.

After re-running the two-stage "dividend" discount valuation modelwith 2014 earnings and the assumptions outlined above, the model concludes AXP is worth $179 a share. This figure is much higher than any sell side analyst price targets. This is an intrinsic value estimate, not a price target. It also implies a 56% margin of safety at the current market price of $79. Please note, this is the book's sheet, not mine. You can get a copy of the model from the books companion website.

It's worth noting a few take away's from this intrinsic value estimate:

The 56% margin of safety is less than the 1994 Buffett purchase margin of safety of 70%.

The assumptions in this model are arguably more conservative than the books 1994 calculation; the risk-free-rate is much lower today, but we used the same 10% discount rate.

To get a 70% margin of safety, AXP would have to trade at $53.

The current price per share of $79 implies a 3% growth rate in owner earnings for the next ten years, followed by 2% growth after ten years.

EDIT 3/16/15: bringing the discount rate down from 10% results in some very steep discounts to intrinsic value.

Is the Costco and anti-trust news important enough compress the earnings growth rate to 2% vs management's 12% to 15% target? That is the question investors should be asking themselves.